Stupid Investment of the Week

BOSTON (MarketWatch) -- Almost three years ago, the Vanguard Group introduced its new Diversified Equity Fund to a fair amount of hype.

The fund -- which invests in eight of the mutual-fund giant's actively managed issues -- appeared at the time to be more about marketing than money management. Nowadays the fund has more than $1 billion in assets, money which has never actually seen the fund live up to its promise, which is precisely why Vanguard Diversified Equity -- for a second time -- earns recognition as a Stupid Investment of the Week.

Stupid Investment of the Week showcases the characteristics and conditions that make a security less than ideal for the average investor, and it is written in the hope that spotlighting the concerns in one case will make it easier for consumers to root out bad ideas elsewhere.

While obviously not a purchase recommendation, neither is the column an automatic sell signal, as there are times when unloading a troublesome purchase simply compounds the problem.

In the case of Vanguard Diversified Equity
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the fund opened in 2005 promising to "provide investors with a diversified, single-fund option offering broad exposure to investment styles and market capitalizations." It's an idea that sells, judging from the money that's piled into the portfolio, but it's not necessarily an idea that pays off.

Mixed and mismatched

The premise is sound -- broad exposure to a range of domestic stock funds -- but the execution is flawed. Not surprisingly, the result is a fund that has been below-average since its inception, based on its Morningstar Inc. peer group, and that provides no hope for superior performance in the future.

In short, this fund was the product of bad chemistry when it was birthed, and it is about to reach its third anniversary of mediocrity. It's not an unqualified stinker, but get your hands dirty sifting through this mess and clearly there's nothing special here.

Typically, Vanguard is considered the white knight of the mutual fund world, focusing on all of the right little things that help investors earn superior performance over time. The firm remains a paragon of fund virtues, striving to keep costs down and to avoid most mistakes that typically trip up flashier shops.

That said, Diversified Equity is a misstep, precisely the kind of stumble for which Vanguard's past and present leaders -- most notably company founder Jack Bogle -- have criticized others.

Six of those funds fall into the large-cap space. Studies have shown that holding more than four funds that cover the same ground results in a "closet index fund," where an investor pays the price for active management but winds up with the performance of an index fund.

Numbers crunch

In the case of Vanguard Diversified Equity, the expense ratio -- including the costs of the underlying funds -- is 0.38%, so it's not terribly pricey, but considering that the Vanguard Total Stock Market Index Fund
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charges 0.15%, you're paying more than double the cost for performance that, logically, is going to be the same.

"The underlying funds are run by 22 different management firms, have more than 30 named portfolio managers and more than a dozen benchmarks, so how could it do anything but mimic the total stock market?" says Dan Wiener, editor of The Independent Adviser for Vanguard Investors newsletter. "This thing is an example of really bad diversification -- diversification by marketers, not investors."

Wiener has researched the issue further, back-testing the fund's performance as if it had been around for the last decade. While there are always concerns about back-testing -- it's the research equivalent of wondering what might have happened at Waterloo if you gave Napoleon automatic weapons -- Wiener's research shows that Diversified Equity and Total Stock Market Index move in lockstep. That's not just the extra testing period, but it covers three years of real life too.

Moreover, Diversified Equity faces overlap issues between its own holdings -- not surprising, since some of the issues share managers -- and there is the undeniable presence of the U.S. Growth fund, which may be the worst fund in the entire family (and which has previously been named Stupid Investment of the Week). It's hard to take Diversified Equity seriously when it holds a fund that has been a dog for at least the past decade.

Diversified Equity is trying to be a one-size-fits-all portfolio, but it's likely to be ill-fitting for most people. There's a noticeable lack of international exposure, for example, and Vanguard has several other fund-of-funds that combine stock and bond exposure, making them superior picks for the investor looking to have a one-fund portfolio.

Performance hasn't given investors a reason to get happy either. The fund has consistently trailed its large-cap blend peers, according to Morningstar Inc., and is off 4% so far this year. (Total Stock Market is down 2.9%.)

"The purpose of this fund is still unclear to me," says Morningstar analyst Dan Culloton, who follows Diversified Equity Fund. "Any one or two or three funds in the portfolio might be a good idea, but all of them together seem to amount to something mediocre, and you have no reason to believe that is ever going to change. ... It's just not a compelling investment idea."

There's a difference between fund ideas that sell and those which make sense to buy. Diversified Equity not only hasn't lived up to the self-generated hype it got when it first opened, it's now proven that it was a good idea for attracting assets, but not for managing them.

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